At the end of last year, the market took a sharp drop. On Christmas Eve, the market was down about 19.9% from its recent high in September, barely escaping bear market territory, which is generally regarded as a decline of 20%. The drop was characterized as a “glitch” by President Trump, which prompted me to write my column, “How the Glitch Stole Christmas” for the Daily Journal of Commerce.

The drop was triggered by two events, the first being the trade war with China. Characterized as “easy to win” by President Trump, the war showed signs of extending and having a negative effect on the global economy. Both Europe and China were showing the effects of slowing, as noted by Christine Lagarde, Chairwoman of the International Monetary Fund. China particularly showed the impact, with its GDP slowing to 6.3% from 6.6%, although still far higher than the EU, the US, and Japan. Still, the longer the trade conflict goes on, the greater the danger of additional global economic contraction. While the U.S. continued to have a generally robust economy, that too showed signs of slowing.

Secondly, the Federal Reserve seemed to be abandoning its support for the U.S economy. With Chairman Powell pursuing an autopilot policy of raising rates, the market lost faith in the Fed as overseer of a strong US and, tangentially, world economy. The market plummeted.

Market suffers steep drop and then bounces

What was that all about?

We all know about volatility. The market is volatile; it has been especially volatile in recent years. Yet, we also know that over time the market gains more than it loses, so we expect volatility, we should stay invested. To do otherwise is to bet against the market, which, again, over time, is not wise.

So let’s look at what happened and why. On Wednesday of last week, the market declined 832 points (as measured by the Dow) or about 3%, the Nasdaq dropped 4%. This was followed by a drop of 546 points before finally recovering part of the loss.

Why did the market drop? In a word (actually two words) interest rates. They went up. It was not just the trajectory. We have been expecting interest rates to rise for some time. It was the speed by which the rates increased. In four days long term rates went up 17 basis points (a basis point is one hundredth of 1 percent). Investors and the markets get excited about sudden moves like that. Also, recently, the Federal Reserve changed the language in their after meeting message to remove the word “accommodative”. That may not seem to be a big deal, but to the markets, it was a big deal. The Fed has been accommodative to the market for years, but now they say they won’t be accommodative. What does that bring? Uncertainty! What does the market and investors not like? All together now: UNCERTAINTY! We have discussed this before.

Tariffs Take Center Stage, U.S. data signals solid growth

QUARTER IN BRIEF

At the end of 2018, economists and journalists may look back on the second quarter and see the moment when a global trade war began. Whether one is truly underway or not, the fact is that Q2 was a good quarter for equities. The S&P 500 gained 2.93% in three months, and while the blue chips had their struggles, tech shares ascended once again. Many foreign benchmarks also had a good quarter, even as the Trump administration’s planned import taxes on U.S. trading partners drew tariffs in kind and bred pessimism overseas. Our labor market and manufacturing and service industries continued to look healthy, and consumer confidence and spending reports were largely encouraging. Existing home sales tailed off. Oil made quite a comeback, aided by supply concerns. It was a quarter in which relatively strong economic data was overshadowed by a shift in the playing field for global trade.

The Return of Volatility

Since the election in 2016, I have cautioned our clients to pay attention to the fundamentals of the markets and the economy and ignore the headline news. That advice has served us well during this time. Events that were unbelievable, except they happened, rocked the markets, causing periodic turbulence. Still the economy improved over the moribund previous years, and the markets rallied strongly. But, had you watched CNBC and taken their comments to heart, or read newspaper headlines, you could be frightened out of your mind. Many investors were frightened and fled the market, to their detriment.

The year 2017 was a remarkable year for investors, despite the political turbulence, as the market surged during this period of remarkable calm as measured by the volatility index. According to the volatility index (VIX), volatility never traded above 19 all 2017.

After a very strong 2017, U.S. equity markets again started 2018 in an exceptionally positive manner. In fact the year to date increase in January has already exceeded some analyst predictions for the entire year. Once more, the question arises, how sustainable is this rally?

The U.S. stock market has benefited from a strong global economy. The global markets are rising in concert with one another, in a convergence not often seen. Indeed, some foreign stock markets have performed even better than the U.S. However, during this time, the U.S. dollar has dropped dramatically in comparison to other currencies. So gains realized in other markets have to be discounted when recorded in U.S. dollars.

These currency risks are one of the reasons we choose to invest primarily in U.S. based companies. Another reason we are not investing directly in overseas markets is that the majority of our companies are themselves already doing business globally. These multinational companies carry our exposure to international markets, and they manage their own currency exposures.

The U.S. economy muddles on, neither too hot nor too cold, but no Goldilocks either. The market continues its ascent, barely, with the economy growing about the same as it did under President Obama. Gross Domestic Product growth inches up toward 2%, meager by any measure, and not the 3-4% promised by candidate Trump. The ISM Purchasing Managers Index of Manufacturing, a key indicator of growth, grew to 57.8% in June, a 2.9% increase over May and its highest level in three years. The PMI services index increased for the 90th consecutive month, to 57.4%, a 0.5% increase over May’s level. The recent jobs report was positive, up 3.7% in the manufacturing sector over May, but jobs growth overall remains at about the level where it was during the Obama administration.

The new President promised accelerated GDP growth through infrastructure spending and reduced regulation. Some of that has occurred, and we have seen a positive impact on bank stocks. Still, we have not seen the robust growth that the market was expecting. Now, we have an expectation of higher interest rates and some tightening of monetary supply. What can we expect from the markets as the recovery looks ever longer in the tooth?

U.S. equity markets experienced an unusually strong showing in the first quarter of 2017, with a 6.1% increase, as measured by the S&P 500 index. Bond markets were also up, 0.8% according to the Barclays Aggregate Bond Index, as prices rose and yields fell even as the U.S. Federal Reserve raised interest rates. The desire for a safe haven investment overcame the Fed rate rise.

Business optimism surged after the Trump election; now many are wondering if the optimism got ahead of reality and was misplaced. Hard data is replacing euphoria. The failure of health care reform and other strategic missteps have given rise to doubts about the ability of President Trump to deliver on his promises. Economists and legislators remain skeptical

Business lending is muted and capital spending has slowed. Estimates for GDP growth are being lowered, Retail sales have been weak and Inflation fell in March.

This year began with a decided down draft for the markets. An improvident rate increase by the Federal Reserve of 25 basis points in December sent an already weak market into a tailspin. Indeed, the indices dropped nearly ten percent into correction territory, the worst start for the markets in history. The market bottomed this year on February 11 and then began an upward climb. Stocks leading the way were interest- sensitive Utilities, because bond yields had dropped so low. Also strong were the previously beaten down Energy stocks. They recovered on the theory that they had dropped so far that they would not go down further, and were due for a recovery. Although this does not always work as an investment strategy, in this case it did. Despite a slowing growth rate for petroleum worldwide, Energy is up 15.3% for the year through July 12.

U.S. equity markets hit an all-time high in May of 2015; this occurred after a long recovery from the Great Recession. The recovery was slow and weak. Incomes have barely reached the levels before the Recession. Unemployment rates have returned to about 5%, but are uneven throughout the country. The labor participation rate has only recently begun to recover. Then in May 2015, markets began a decline. A confluence of factors led to the decline. The economy of China began to slow. This slowdown led to a collapse of commodity prices, especially oil, throughout the world. Normally lower oil prices would be considered good news, a tax cut really. But in this case, the drop was so significant and rapid, that producers were caught off guard. Commodity producers of all kinds had expected the Chinese economy to continue to grow; they invested and created overcapacity. In the case of oil, the U.S. became a net exporter, which had not been the case for decades. Emerging markets began to falter. Banks were under pressure again. Equity markets decided to steer clear of all this risk. Central banks throughout the world cut interest rates, some into negative territory. Currencies weakened as central bankers tried to reflate their economies with a weak currency. Into this witches brew stepped the U.S. Federal Reserve with a benighted policy to raise interest rates. They forecast four rate increases for 2016. Then having painted themselves into a corner, they did raise rates in December of 2015. The markets responded immediately tumbling more than 10% in the worst start ever to a new year. Remember the adages, “As January goes, so goes the year” and “Don’t fight the Fed”. Investors […]

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